Why Apple Inc. Wants to Build Its Own Graphics Processors

By Ashraf Eassa Markets Fool.com

On April 3, graphics intellectual property vendor Imagination Technologies (NASDAQOTH: IGNMF) disclosed to investors that its largest customer,Apple (NASDAQ: AAPL), hadinformed it that it would no longer need its technologies going forward because it will shift completely to in-house graphics technology.

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Given that Apple has successfully used Imagination's technology for years (although microprocessor expert David Kanter says that Apple has been significantly customizingitfor several generations), why would it want to make a clean break?

Image source: Apple.

It's not about the money

I've seen hypothesis thrown around that Apple is simply looking to cut costs. As Imagination disclosed in its announcement, its revenue from Apple in its current fiscal year is expected to be around 65 million pounds, or roughly $80 million.

The royalties that Apple pays to Imagination for technology licensing probably show up on Apple's income statement as part of its cost of sales, ultimately impacting gross margin.

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For some context, Apple's cost of sales during its fiscal year 2016 were $131.376 billion. If we strip out those royalty payments from its fiscal 2016 cost of sales, we get total cost of sales of $131.296 billion. The difference is essentially a rounding error.

Furthermore, to build its own graphics technology, Apple needs to invest substantially in research and development. The R&D expense required to keep a pipeline full of leadership graphics intellectual property likely isn't trivial and would almost certainly negate, if not more than offset, any savings on the cost-of-goods-sold side.

This isn't about the money.

So, what's it about?

The bottom line is that graphics technology is likely to become increasingly important over time. Not only is leadership graphics technology critical to enabling applications such as mobile gaming and high-resolution displays, but graphics technology is likely to become even more important as augmented reality (AR) and virtual reality (VR) -- both areas that Apple is said to be working on-- potentially go mainstream.

Graphics technology is a critically important asset, and I suspect that Apple thinks that it can do a better job of building its own graphics processors tailored to its hardware and software needs than Imagination can.

Although it may seem as though Apple is being a bit arrogant here, thinking that it can build better technology than what a company that's been doing this for a long time has been doing, it's worth keeping in mind a couple of things.

First, Apple has been scooping up graphics talent for many years now and that talent doesn't just consist of new college grads -- it has hired experienced engineers and managers from many of the top graphics companies in the industry to get this done. So, even if Apple is relatively new to graphics, the teams that it has tasked with building this technology certainly comprise industry veterans.

Beyond that, Apple can now build graphics processor technology to its own specifications, without having to worry about building technologies that need to be applicable to a broad range of customer needs.

Moreover, Apple can afford to throw much more money at building graphics technology than Imagination ever could. Remember that Imagination's operating cost structure is fundamentally limited by the fact that it needed to develop graphics processors and other technologies while turning a profit on a relatively small revenue base.

Apple's financial position allows it to be able to spend multiples of what Imagination can, which could ultimately lead to better products custom tailored to Apple's needs.

And finally, I think Apple's silicon engineering organizations deserve the benefit of the doubt. Apple has built world-class mobile chips with industry-leading CPUs, image signal processors, and other key technologies. Given its execution in every other area of its chip technology, there's little reason to doubt its ability to build great graphics processors.

This might be bad news for Imagination, but this is likely good news for Apple and its customers.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.